Each month, the newsletter will have articles on new developments in the fixed income market as well as educational and informational pieces designed to expand our readers knowledge and understanding of these securities. A library of such past articles as well as of the columns done by Richard Lehmann in past issues of Forbes are available.
The Financial Crisis Report
The December 2010 release of the report by the Financial Crisis Inquiry Commission proved to be controversial because of the split among the members on what were the causes of the crisis. The official report lists nine 'findings and conclusions.' One dissenting report by three commission members lists ten and the other dissenting report lists mainly one. Congress, in its collective wisdom, decided it need not wait for this report to legislate a remedy via the Dodd Franks financial reform legislation. As you can guess, this means the crisis was used to address unrelated problems and further social legislation.
While my subscribers may feel I'm a little slow to be writing about a report released back in December, this report is no easy read except for media types who specialize in thirty second sound bites. The report is very comprehensive, is well written and provides study material for much more extensive analysis than was done in the limited time the commission was given to produce it. It is supported by a website www.fcic.gov which provides detailed reports, interviews and videos of testimony which will allow a more thorough and balanced analysis of events than the commissions findings. It will be years before a consensus is reached.
To get a broad understanding of the crisis, it is best to think of it as two separate events. The first was the collapse of the mortgage market and the second the institutional financial crisis that ensued. In brief, the commission found that the mortgage crisis was caused mainly by the following:
- Deteriorating mortgage standards
- Inadequate regulatory supervision
- Poor risk management by the financial firms
- Improper ratings of CDOs and CMOs by the credit rating agencies
To these causes I would add three additional ones left off by the commission, probably for political reasons:
- FHA quotas for affordable housing loans which ratcheted up to a 50% goal in 2006 for the likes of Fannie May for all new mortgages.
- Fannie Mae and Freddie Mac missteps
- Federal Reserve interest rate policy which fueled the housing boom
The sequence of events here is that as far back as the Clinton administration, the government decided that poor people should share in the American dream and become homeowners. Since they had no down payment money and poor credit scores, normal mortgage standards had to be waived. Since lenders would not do so on their own, the government strong armed banks into such lending by tying it to their getting permission for mergers and expansion. They also pressured Fannie and Freddie who were hardly in a position to say no and saw opportunity to enhance their bottom line at the tax payers risk. It is not hard to sell a house to a poor person if he needs no down payment and if the initial terms are tailored to what he can afford.
What ensued is a housing boom that also lead to rapidly rising prices. The price rises, in turn, created a continuous opportunity for those same poor people to refinance their houses whenever they got in trouble or the easy teaser terms expired and real money was needed to continue ownership. The price rises had the perverse effect of disguising the true default rate for these sub-prime mortgages which is how the credit rating agencies were fooled into believing you could structure these low quality mortgages into CMOs and other derivative instruments and still rate them AAA. Another perverse effect was that many who were seasoned prime mortgages used their home equity like an ATM card to tap the rising equity to buy consumer goods. Thus, when home prices plunged, many of those mortgages became at risk as well. The banks and even mortgage originators were also fooled into believing price rises could go on forever and had no idea what would happen if they did not. They therefore kept on their books too many mortgages that should have been sold.
The good times were kept up far too long by the Fed's continuing to supply cheap money despite the obvious overheated nature of the housing market. Their motivation in this regard is suspect. One suspicion is that Alan Greenspan, who had to retire in January 2006, did not want to take the blame for what he knew would happen if he reigned the housing market in so he left it to his successor. Other suspicions, however, come to mind.
What did bring the good times to a halt was that by 2006, half the US housing mortgages or 14.5 trillion dollars worth, where non traditional mortgages. House prices had gotten so high that there were fewer eligible candidates for new purchases even at the depth to which standards had sunk. House prices stopped rising and suddenly, the ability to refinance your way out of a mortgage you couldn't afford disappeared. Defaults began to rise and reality set in.
According to the commission the financial crisis that ensued was mainly due to the following factors:
- Bad accounting and reporting and a low standard of ethics
- Excessive leverage by the financial institutions
- A poor government response to the crisis
- Financial derivatives
To these I would add the failure to suspend 'mark to market' accounting which the commission failed to even address. It greatly magnified and concentrated the mortgage valuation problem, allowed derivative investors to game the system and added to the perception of insolvency for many of the financial institutions which then had to be bailed out.
The media has made much of the pay excesses that preceded the financial crisis, but these are hardly new. Manipulating the accounting to maximize compensation has been around since the first performance bonus plan was created. Excess leverage is just one of the ways to enhance results. It is also a main reason you need government oversight of financial institutions.
The poor government response to the financial crisis was something I commented on when I previously wrote on Hank Paulson's memoirs. They were always behind the curve in dealing with the crisis because they perceived it as still a liquidity problem long after it became a confidence problem. I never understood why Bear Stearns, Wachovia, Washington Mutual, Merrill Lynch had to be merged into other firms while companies like Citibank, AIG, GM, and Chrysler did not. Likewise, why Lehmann Brothers was allowed to fail when no partner could be found. The rational given that the government did not have the authority to help Lehman doesn't wash given the way they made their authority up as they went along and given that a few weeks later all the other investment banks became members of the Fed and drew down all the cash they needed. It was the Lehmann bankruptcy that really shook up the financial markets and created a panic atmosphere, greatly worsening matters.
While the Financial Crisis Commission points fingers in many different directions, I believe it can be fairly said that the root cause of the crisis was government meddling. FHA arm twisting to promote affordable housing led to trillions of dollars in bad mortgages. Federal Reserve laxness in setting low interest rates allowed a housing bubble to form. Banking and other regulators turned a blind eye or were reigned in by Congressional pressure. Congress set the stage for the crisis by legislating housing policies for which they had no understanding of the economic consequences and then legislating remedies which miss the mark and promise instead, a whole new set of problems. When the crisis hit, The Treasury and Fed were not prepared to deal with it and did so in a haphazard manner. The ultimate consequence here will be Fed induced inflation which solves some short term problems but, promises a whole set of new problems. So much for democracy in action.
Inflation - The Negatives
While my comments last month focused on the positives of inflation, at least from the governments perspective, its long term and overall effects are always negative. The only reason it gains any traction in government is because it has various positives in the short term for government bureaucrats and politicians, which I detailed last month. Aside from the fact that last month's inflation positives are mostly negatives for other than government and debtors, let's review some more negatives:
1. It discourages investment and erodes savings thereby making planning and budgeting by individuals and industry hesitant and uncertain.
2. It causes an allocation of more capital into nonproductive assets such as gold, collectibles, land, etc.
3. It causes hoarding and speculation which leads to price distortions, i.e. it is self- perpetuating.
4. It erodes peoples' pensions and retirement savings so they cannot afford to retire. Those already retired face a reduced quality of life or becoming Walmart greeters.
5. It leads to tax bracket creep for individuals increasing their tax rates in addition to the total tax amount.
6. It increases labor strife and disruptions as wage negotiations make unions more importance to workers.
7. It causes an inefficient allocation of resources resulting from the constant need to raise prices, which is also costly, e.g. restaurant menus.
8. It leads to speculative borrowing which increases investors' risk as well as overall systemic risk for the financial system.
9. It invariably leads to an economic contraction when government decides the negatives outweigh the positives. They do this through raising interest rates and shrinking the money supply.
10. As inflation drives up interest rates, the cost to the federal government of financing a $14 trillion debt at say 6% becomes $840 billion a year - the amount of the entire budget not so long ago. This alone would be a $350 billion increase in federal spending over the cost today, which shows just how marginal is the current debate over getting $100 billion in annual budget cuts.
The consequences of inflation for the federal government are a host of new problems, usually involving the spending of more money to counter the economic contraction they caused in the first place. But then, this is the history of government actions, a high percentage of which are directed at remedying past policy mistakes.
Individual investors need be pro-active if they wish to avoid the consequences of inflation. My recommendations for asset allocations are:
- 25% in adjustable interest rate debt securities.
- 30% in stock market sensitive issues, i.e. convertible stocks and high dividend paying blue chip stocks.
- 20% in energy securities and master limited partnerships.
- 15% in high dividend paying special purpose closed end funds, i.e. commodities, energy, adjustable rate debt and stocks.
- 10% in gold, silver and platinum ETFs.
We follow this strategy for our managed accounts and attempt to achieve this diversity in the Multi-driver Portfolio shown on Page 9. Space limitations, however, prevent us from building such a portfolio in the newsletter. This is why it is important for investors to use these portfolios as a guide for building their own portfolio with a broader selection of holdings and with additions throughout the year as holding mature or become too pricey or too risky.
Inflation - The Positives
Inflation has always been viewed as a consequence of poor economic policies or planning. Never do we hear of it being seen as an instrument of deliberate economic policy. This is about to change.
The reasons inflation carries such a negative label are many, prime of which are that it is a tax on wealth and people with wealth generally govern, but not always. We know from experience that liberal politicians see nothing wrong with the haves supporting the have-nots. Government is their preferred vehicle for forcing this process to occur (most haves prefer charitable giving.).
Government tries to get the haves to relinquish a fair share (an amount well above biblical guidelines, but otherwise undefined) of their earnings through high tax rates. However, since government cannot always get tax rates high enough to meet your spending plans without also damaging the economy, they tax wealth through planned inflation. It would be naÃ¯ve to think that this alternative has not occurred to our politicians or to believe they are not actively pursuing such a policy. After all, it's a policy that can be implemented in secret, with no votes taken or even admission that this is what's taking place. While inflation does not itself redistribute wealth, it does put more money into the hands of those who see themselves as the wise arbiters of who should have how much. For them, far be it to hand such an important goal to the anonymous 'market' to make such important decisions. A good way to start would be to begin massive spending during a crisis (a word defined today as 'a terrible thing to waste'.)
What then are inflation's virtues?
1. Government tax revenue based on income, property values and sales will all take gigantic leaps as inflation kicks in.
2. Government spending will lag the inflation rate creating a surplus which is needed to service the huge debts incurred and, over time, increase the capacity to take on new debt. This cheapening of debt effect is also true for the trillions of dollars in unfunded mandates such as social security, health care and government pensions. How often did you read or hear the term 'trillion dollars' before 2007?
3. The current housing and mortgage crisis will be remedied much quicker with high inflation. The unsold housing inventory will be bought up as an inflation hedge. Mortgage holders will be less inclined to default since their houses are now appreciating assets. New home construction will restart, stimulating an important economic driver.
4. Economic growth, in nominal terms, would make our reported statistics look like China's or Brazil's. Underlying growth would probably improve as well since complacency in the private sector will lead to failure by the least efficient as survival means you have to run faster to stay even. Likewise, many bad investments made during prosperous times will be bailed out by inflation since the value of their output can now show inflated profits. Sales and output will rise as consumers scramble to buy today what they know will cost more tomorrow.
5. Corporate profits and stock prices will rise as reported double digit growth rates make the haves feel like inflation is not so bad after all. If inflation is accompanied by dollar devaluation, so much the better. With most of our large companies doing a large share of their selling abroad, currency accounting profits only add to the joy.
6. While inflation is disruptive, it has the virtue that those it doesn't kill it makes stronger. It is the instrument for moving resources from the hands of the weak to those which are strong. It punishes inherited as well as earned wealth poorly employed.
For a liberal politician, all this is nirvana. My best scenario for 2011 is that by mid-year, the Fed will be finished with its QE2 program for taking the banks and others out of their carry trade positions at below free-market yields (dare I use the words 'bailout 2'). This means long term rates will now be free to rise based on free market forces. Then, as banks redirect the capital previously employed in the carry trade into commercial loans, economic growth will increase, but the velocity of money will also rise. It is this increase in velocity that drives inflation, and Mr. Bernanke has said he wants to see more inflation. In short, don't fight the Fed.
Next month see what's wrong with this picture, meanwhile, position your portfolios in expectation that serious inflation will happen.
It Was a Very Good Year
Once again, we are glad to report that our model portfolios outperformed the stock market indexes for the year and continue our winning streak that now runs to eleven straight years. While the financial crisis left most stock investors about even for the five year period, our income portfolios are ahead by 25% to 85%. So where do we go from here?
The outlook for 2011 is generally considered positive for stocks and neutral to slightly negative for fixed income. We agree that stocks look promising given that the recovery is long overdue. While there is lots of moaning about the unemployment rate at 9%, this is not that significant economically since 6% was always viewed as "normal". Given a 6% normal rate this means that, for the US labor force in total, about 3 million more people than normal are unemployed while about 97 million are employed; even if 96 million of those would like to be paid more.
While the picture for stocks is positive, the same cannot be said for income securities. The Fed has been keeping short term rates artificially low since 2008 despite obvious inflation in food, commodities and energy. A resurgent stock market means money will be coming out of low yielding income securities and going into equities; we see some of this already happening. While the Fed can continue to hold short-term rates below the 4% level at which it should be, its control over long-term rates is tenuous at best. When QE2 is over, the Fed will own another $600 billion in treasuries (see our December issue where we explain what QE2 is really about). Will it then still defend long-term rates at current levels? I think not, which means rates are going up and the Fed will either have to hold those long term Treasuries to maturity or take massive losses selling them off. Aside from this the government will have to finance the huge deficit in 2011 in a market that will be unwinding carry trade positions in treasuries in order to shift over to the stock market. Unless the Chinese have still not had their fill, there may be a problem selling this debt at anywhere near current rates.
This issue features our new 2011 model portfolios. They mirror our principal concern, namely inflation, and therefore include adjustable rate debt, convertibles and energy and commodity linked issues. While this can only be done to a limited extent in the low, medium and high risk portfolios, the drivers portfolio more fully reflects the diversification I am seeking. In any case, however, space limitations require we diversify among only 9 or 10 individual securities. I advise you to use our monthly selections to add additional names and sectors to your holdings, particularly in the area of convertible issues and high dividend stocks.
QE2 - Not What it Seems
Markets are presently debating the merits of QE2, wondering what Chairman Bernanke is thinking. After all, what can $600 billion in purchases of long term treasuries over the next 3 quarters possibly do to stimulate the economy when banks are already flush with money and not lending it out to business? The reason for the confusion is that the market is pondering the wrong question. QE2 is a convenient disguise for what is really going on.
The Fed has been encouraging banks to engage in the carry trade in order to rebuild their capital base (carry trade is when you borrow short term at a .25% interest rate, typically using up to 10 times leverage, to buy long term treasuries yielding 3.00% or more.) This is risk free as to credit quality, but a bigger risk would be a sudden increase in long-term interest rates. It's fine to collect 30% a year's worth of carry trade interest, but not if long term rates suddenly move up. A 2% rise at 10 times leverage would result in a 33% capital loss, or more precisely, a wipeout. A year ago this carry trade looked to be about $500 billion and I suspect it has grown since then. What made this bet look risk-free was the Fed promise is wouldn't change the short term borrowing rate for some time and then only with plenty of advanced warning. The more important signal, however, is the rise in long-term rates; rates over which the Fed has only limited influence.
Those who engage in this carry trade game look for the first signs of a long-term rate rise. When they see it, they will rapidly de-leverage their holdings to avoid the rate spike that can occur when everyone sees what's coming and tries to bail out at the same time. And what better first signs can you have than for the Fed Chairman to announce he wants to see more inflation combined with the market surge in gold and commodity prices?
When the carry trade exodus starts, the Fed will have to step up to fill the void, but at what price level? To forestall the uncertainty and head off a selling surge, the Fed announces it will become the buyer of last resort for these treasuries at current market levels over the next 3 quarters, but calls it QE2. I believe this is Bernanke's way of telling his banker friends it's time to unwind their carry trade positions and get back to the business of lending to the private sector. Yes that means taking credit risk, but it also means making loans tied to the prime rate and therefore, loans that adjust with the coming inflation.
Now God forbid the Fed should tell us this is what is going on, it will only be perceived as another bank bailout (which it is.) Better to keep us guessing to slow down the market reactions and to avoid those unintended consequences. And what are those unintended consequences? I don't know, but they are usually bad. While I agree that the Fed has to buy up these treasuries to slow down the inevitable rise in long-term rates, it was the consequence of an equally bad policy of encouraging the engagement in the carry trade at the expense of savers in the first place. I'm not sure Chairman Bernanke anticipated all the fallout and misunderstanding so far, but he sure can play a mean game of monopoly.
Income investors should heed Bernanke's warning and exchange their fixed rate bonds for adjustable rate issues. They should also look at including some high dividend blue chip stocks, securities that should do well if inflation hits or in a buoyant stock market next year. Keep in mind that when the Bush tax cuts are extended, these dividends will be taxed at only 15% versus ordinary income rates for interest. That alone should boost these stocks' prices.
Lessons From History
It's sad how history has a way of repeating itself, especially when repetition is a bad thing. Our current best example is the trade imbalance with China and that countries refusal to address the problem in a meaningful way.
In the 18th century China was one of the leading nations of the world. It was prosperous, economically self-sufficient and isolated. European countries came to China to buy its tea, silks and spices and offered European industrial goods in exchange. But, the Chinese emperor would have none of the European goods, which he outright banned. Hence, gold and silver were the only acceptable medium of exchange. A problem developed with this trade arrangement in that it was draining Europe of its gold and silver, i.e. its universally accepted currency. In economic terms, this meant trade in Europe was slowing down due to a shortage of currency.
This clearly intolerable situation was remedied when the Europeans found a trade product that the Chinese people wanted, opium. This too was banned as an import by the emperor, but as with all such illicit goods, smuggling on a massive scale occurred. When the emperor began a serious crack down, European ships of war appeared on China's coast to break the ban resulting in the opium wars in the late 1800's. Too late did the emperor discover that there were European goods he needed, modern tools of war. A second remedy the Europeans found was to grow tea in colonial India thereby stripping China of its main trade good. The subsequent decline of China as a world power can be traced back to the decision to ignore the need for reciprocity in trade.
Now fast forward 200 years and we see China once again as a world power and once again practicing trading as a largely one sided arrangement. Will this situation end badly once again? Sad to say yes, only this time there will be no need for warfare to settle the issue. China has fooled itself again, this time in believing that holding their trade imbalance in dollar denominated treasury bonds represents a fair bargain. But this time, there's no danger that their dollar reserve accumulation will drain the currency of exchange from the world trade system. It's more like that Doritos commercial featuring Jay Leno where he says, "Crunch all you want, we'll make more". The fact is that the dollar, unlike the gold and silver of old, is a depreciating resource, a fiat currency. Where China to begin aggressively spending its accumulated reserves in the US, it would quickly fuel inflation and thereby cause the dollar to depreciate even faster. There is no fault here, the Chinese economy is really not geared to buying massive amounts of the things we produce. Domestic markets need to evolve and that takes decades.
What China buys from us are high tech goods and agricultural and other commodities. Pushing them to increased purchases of either of these will not significantly improve the jobs picture in the US since these are both relatively low labor content goods. Congress should recognize that the current trade imbalance is a huge plus for us. We take their goods and give them paper in return. We can print as many Doritos as we need to because there is currently no alternative for China. Well actually there is, but China is probably too conservative to take the risk.
One alternative for China is to declare itself the buyer of last resort for gold, i.e. it will buy all that is offered for sale at their specified dollar price. This is not going on the gold standard, but rather, it's a hijacking of the valuation process for both the dollars and gold. To implement such a policy, they should currently be busy secretly buying all the gold they can. When their buying finally attracts world attention, they would announce the new policy. With the announcement would also be the setting of this month's dollar denominated benchmark gold price. As frequently as they need to, they can ratchet this price upward to preserve the buying power of their combined gold/dollar reserves or to gain other advantages yet to be discovered.
How would the gold market react to such a policy? They would probably bid the price of gold above the benchmark price once this policy achieves credibility. How would the US government react to such a change? I don't know, but personally, I think they should be mighty scared. Perhaps even scared enough to adopt such a policy for the dollar.
The US needs to forestall China seeking radical solutions such as this since alternative solutions could be even more disruptive to the world economy or negative to the US. We can't count on China making the same mistake as Japan in the 1980's when they tried to remedy the trade imbalance by buying US real estate. But we should recognize that we are forcing China's hand if we continue to let the dollar decline and I fear that the outcome will not be pretty for either party or the world as a whole.
The current economic problems for the US are the result of decades of government mismanagement. The solution is either strong growth or inflation. There does not seem to be the political consensus needed to spark strong growth so inflation and therefore, dollar depreciation is the prospect. The effect on China would only be one of any number of negative unintended consequences. You thought the recent financial crisis was over? Hard times have just begun. If you have not yet diversified your portfolio to protect against inflation, there has never been a better time than now.
Income Investing Wins Again
It's become routine for us to announce that once again, income investing has outperformed the stock market. By routine, we mean most years since 2000, when we first began publishing our model income portfolios. Sad to say, stocks still prevail in the thoughts of most investors and most investment professionals. This is truly a sad situation given the dismal outlook for stocks and given the savings needs of an entire generation of baby boomers who have suffered dearly in 2008 and are facing a serious redo of their retirement plans. We will continue to try to influence this mindset, but fear we are battling an investment industry that will continue to sell the myth that stocks for the long run are the only way to go. I guess some people will never get it, but our faithful subscribers do and I hope will continue to benefit. Yes, equity investors are going to catch that once in a decade bull market provided they live that long and have money left to invest. We wish them well.
Looking forward, I see an increased awareness that inflation is now the main concern of income investors and that interest rates can only go up from here. Reinforcing this perception is the Fed's perception that the inflation rate is too low to which gold shot up and the dollar sank. Can interest rate rises be far behind? Those who have not yet responded to my urging that they buy some adjustable rate securities may want to reconsider this option. Aside from this, oil trusts, convertible closed end funds and gold continue to be alternatives benefiting from the increased level of concern. In any case, I believe we are at or near a turning point for income securities and maybe for stocks as well. Whether the turn is for better or worse is still unclear, but be thinking defensively. One thought for those with tax sheltered accounts, The Canadian trusts have mostly converted to corporations and as such, will no longer be subject to Canadian withholding tax for US tax sheltered accounts. This means you should now hold Canadian energy stocks in your IRA rather than your taxable account and thereby keep 100% of the dividend distributions. This may be the last actual tax cut you will see in your lifetime, for which you can thank Canada.
If the above prediction plays out, we should see a stock market sell-off in late 2010 as individuals take profits and sit on the cash. Then, as the change in tax policy appears in early 2011, a market rally is likely, fed by cash and renewed confidence that divided government can work. This result would not only be good fiscal policy, its good economics. The government gets additional tax revenues now instead of years from now and the rich pay more in taxes, but do so because they chose to. It's only important that they not know they were being set-up all along.
If the above prediction plays out, we should see a stock market sell-off in late 2010 as individuals take profits and sit on the cash. Then, as the change in tax policy appears in early 2011, a market rally is likely, fed by cash and renewed confidence that divided government can work. This result would not only be good fiscal policy, its good economics. The government gets additional tax revenues now instead of years from now and the rich pay more in taxes, but do so because they chose to. It's only important that they not know they were being set-up all along.
Investing for the Next Decade
I read today that the Dow Jones Industrial average shows a net loss of 0.9% for the last decade ending December 2009. Since then we see only further erosion. Are we at a bottom just before a massive rally or are we at a Business Week moment when their headline reads "The Death of Equities", which today reads as "The Hindenberg Effect"?
Either way, it begs the more important question of where do investors go for long term safety and income. Our model portfolios of income securities did dramatically better for this same time period, growing a $1 by 95% to 132% for the same time period. Nevertheless, the outlook for the next decade calls for a more targeted investment approach.
Traditional refuges; your home equity, stocks, mutual funds, variable annuities and CDs have all shown to be vulnerable and promise little hope of long-term viability. Even our favorite, fixed income, shows real vulnerability given the inflation outlook. Inflation is the great scourge to accumulated wealth. It is government's way of taxing wealth, something they resort to when they can no longer raise revenues by increasing the tax rates on income. Inflation, arguably, may not come tomorrow, but come it must. There is just no other solution to the many budgetary problems faced by government at all levels around the world. I am saying, in short, that inflation will occur because governments need it to occur.
I'm old enough to think that I have learned a few things to pass on. I would do my readers a disservice if I went along with the popular rhetoric that things will get better if we just give it a little time. Experience tells me its not going to happen. Governments around the world have got it in their heads that they know what's best, ignoring the fact that they, not private enterprise, are largely responsible for the intractable financial and budgetary mess we are all in.
The current financial malaise will largely continue for a variety of reasons. Most of the world is facing a demographic shift wherein a disproportionately high percentage of the most experienced workers are headed for retirement and are counting on pension and health benefits that have not been provided for. Hence, we have built in declines in productivity and budget shortfalls to fund what are essentially subsistence expenditures. You can't grow an economy in that environment, and government can only borrow its way out until lenders get smart and demand interest rate returns they can no longer afford. At that point, they just print money to pay the bills.
I could go on about all the woes we face and how we got there, but the more important point of this article is what should income investors do different given that traditional ways of wealth accumulation and preservation are broken. Here then is my list of broad categories of investments individuals should position for the long run:
1. Gold - For wealth preservation there is no substitute. There is only about $5 trillion of gold in existence and only small net additions to the supply occur each year. Since I expect all currencies will be debased, you want to have an asset that can't be.
2. Adjustable Rate or Step-Up Debt - These are securities whose interest payment is tied to some index such as the consumer price index, LIBOR or a treasury rate plus a fixed component. The adjustment factor assures that the price of the security does not fluctuate greatly from its face value. They should have a floor rate (usually 3% or 4%) and may have a ceiling rate as well. The step up variety offer a sweetener rate for the first few years. U.S. Treasury TIPS offer similar protection, but the yield is way lower and they tax income not yet received. In selecting these securities, pay close attention to the call features to assure they aren't called away just when you need them the most.
3. Energy Funds and MLPs - Past experience has shown that oil has adjusted very well for inflation over time. Unfortunately, most oil investments get dragged down because much of what comes out of the ground with the oil is natural gas and it has done poorly. Buy them anyway for their high cash dividends and, in the case of MLPs, their tax preference status.
4. Convertible Securities - Non-mandatory convertible bonds and preferreds paying 5% or more offer decent returns and a variable amount of inflation protection. Some issues, where the conversion value is well below the current market price of the common stock into which it converts, offer yields of 7% or more. They still offer some inflation protection should hyper-inflation occur. Pick companies in industries that can thrive despite inflation such as commodities and real estate.
I could go on with this list, but the long-term inflation protection value of other alternatives, such as REITs, is further off or less predictable. Take advantage of the lower current capital gains taxes to restructure your portfolio into the above asset categories. This is not a change you need to make overnight, but it should be a long-term direction for restructuring your portfolio.
Congress adjourns, stock market rallies! This is an important time in the election cycle since candidates up for re-election will be going home to get an earful about what they need to do to please voters. The best we can hope for is that this will translate into an extension of current income tax rates in October, which would produce a nice market rally and forestall a lot of tax selling before year-end. While we have heard White House resistance to the idea of extending the Bush tax cuts, this just may be posturing to postpone the actual extension legislation until October, when it will do the most political good. If you were contemplating taking some of your capital gains before year-end, hold off until after the November elections, assuming the Republicans still look good to win the House. If they don't, expect a market shock that will last well into 2011.
July proved to be a good recovery month for income investors, at least for those invested in our model portfolios. Corporate bond yields dropped to 2.86% for AAAs, which is below the 2.90% rate for comparable 10 year treasuries. This rate anomaly occurs from time to time and is more reflective of a shortage of AAA corporate paper than that the US government is less well thought of. What is hard to fathom is who can find a 2.86% yield on a 10 year corporate bond, for which you must pay a significant premium above par, attractive. I continue to advocate investors putting up to 20% of their portfolio in adjustable rate securities. These securities are paying 3% to 5%, have little downside risk, sell below par, and give a lot of protection should government finally get the inflation they secretly desire.
Municipal bonds made a strong showing in July with AAA yields dropping to 2.76%; which again means, you have to pay considerably above par value to buy them. When are investors going to learn that credit risk is only one, and in the case of munis, the lesser of their worries? Market risk at these prices is ridiculously high, more so because unscheduled calls are a real concern when an issuer can reissue bonds at such low rates. I say unscheduled calls because we have seen numerous AAA issuers use this ploy to take advantage of low rates. While on the subject of munis, check the portfolio of your muni bond fund. If they have a large percentage of tobacco bonds, you may find it prudent to exit. We note such bonds are trading as low as 66 cents on the dollar for these high coupon rate bonds. The concern here is that tobacco consumption is dropping faster than anticipated by the debt payment schedule on these bonds, so payment delays could be in the offing.
I see little reason for market trauma between now and November, but then there are always those foreign elements which may try to influence election events here, or worse, take actions they would see as less likely to succeed in another time. Deflation fears dominates the current conversation on economic outlook, driven in the main by the Federal Reserve Bank, which would otherwise be accused of recklessness.
Income investors can once again take solace in the fact that their investment approach continues to outperform equities. Those fortunate enough to invest in our model portfolios saw all risk categories show positive results. Equities of all persuasion saw mid-year losses after a first quarter surge. Only our multi-driver portfolio showed negative year to date results because of its partial exposure to the stock market. This is not a reason to abandon this approach, however, unless you feel you are smart enough to time the market (note that for 2009 it was the best overall performer).
What accounts for the second quarter downturn? Various theories are being put forward. One is that corporations are pulling profits forward into 2010 to avoid the higher taxes coming in 2011. Yes, it is still possible to manipulate earnings despite Sarbanes-Oxly, you just have to be smarter than before. Another possible reason for the decline is the fear of a double dip recession starting early next year. This is supported in part by numerous factors including robbing 2011 results by the earnings manipulations described above, expiration of the Federal economic stimulus (yes, even bad stimulus has some effect on the economy) and uncertainty arising from the fallout expected from the financial reform legislation now pending in Congress and the actual fallout from the health care legislation. Finally, there is the expectation that corporate earnings and competitive position internationally will be negatively affected by the higher corporate tax rates in 2011. The often repeated mantra that 'the more you tax something the less of it you get' is running into opposition by the Obama administration which is more concerned with 'fairness'. Taxation should be about raising the maximum amount of revenue for the government in the least economically disruptive way. Fairness should be addressed on the spending side of the ledger. To mix the two politicizes revenue raising and invites special interests to corrupt the taxation process with social engineering thereby doing greater harm to the economy.
Individual investors have still to be heard from since they are expected to take profits on their holdings before year-end to avoid higher tax rates. Such individuals may well opt to sit on the cash proceeds from such tax sales until the outlook clarifies. This will only add to short term market weakness.
Despite the fact that Congress seems to be playing a losing hand, they seem unlikely to change course before the November elections. Should the Democrats lose control of the House of Representatives, we can expect a major market rally since a stalemated Congress would be a welcome relief for the markets. This may be short lived, however, since a lame duck Congress may well try to finish their agenda before leaving office (think carbon tax or a VAT). In short, equities don't look promising between now and November and don't look all that great for next year. A healthy position in cash and gold still look like safe bets.
We live in interesting times. I think it was the Chinese who originated this phrase though not as a blessing, but as a curse. We see today a world in economic and political turmoil with political turmoil in half a dozen major countries and economic growth on life support in even more. In the United States we are entering the political season with the control of Congress in the balance. It will not be pretty, but I am confident that after November 2 we will all be happy, happy that it is finally over. Investors need to begin thinking in terms of shortterm strategies between now and November because they may be significantly different from those for the longer term.
In this regard, we sat down and theorized about some of the things with consequences to income investors that are likely to happen so that we can posture ourselves for those consequences. You may agree or disagree with some of these predictions and we invite you to come up with your own list that we hope you will share with us. We do believe that the current Congress will do whatever they think will help their re-election chances even if it adds to the deficit or further polarizes the electorate. This election will not only decide the makeup of Congress, but also numerous statehouses. It is those statehouses which will be acting on the 2010 census data to redistrict Congressional seats which means, to maximize their safe seats in Congress. Here then is our list of predictions and their consequences. The gulf oil disaster will become the three mile island debacle for the offshore oil and gas industry. New regulations and drilling restrictions will raise the cost of offshore production which will drive up the cost of oil. The President also sees the disaster as another reason to pass cap and trade legislation. This strained logic will only delay development of a coherent energy policy, so oil prices will remain volatile. Canadian oil and gas producers will be big beneficiaries.
The Bush tax cuts will be extended for another two years. This will give rise to a significant stock market rally. More importantly, it will forestall the massive profit taking in the fourth quarter of this year which promised a windfall of tax revenues for the government. But, as people took their long term capital gains, they would likely leave their money parked on the sidelines rather than reinvesting which would slow the market in 2011.
The financial regulation legislation currently being finalized by conference committee in Congress has added to the depressed stock market. Expect this legislation to pass shortly and only be understood later. It should result in calming the markets since its negative aspects will only be known down the road. On the positive side, expect the witch hunt against Goldman Sachs and the major banks to drop out of sight and eventually die since their campaign contributions are very generous. The government will sell a portion of its stake in GM. There will be great demand for this stock as it will need to be included in the S&P 500 index so it should be over-subscribed. If you hold any of the GM debt issues, you may have an optimal time to sell these after the stock value has been established since the debt holders will be getting stock once the bankruptcy has been confirmed.
Gold is being driven by fears of inflation and uncertainty. Since the EU crisis with Greece gold has regained its identity as a reserve asset by central banks now that the euro looks like a doomed currency. The elections will give rise to a great deal of political posturing by the White House on both the domestic and international stage. However, count on public fear being played on by both parties. How will gold do during the election season? It will do nicely.
Unemployment is unlikely to improve significantly in the next five months as Congress will continue to extend unemployment benefits at least through November. Hence, additional stimulus spending is likely. There is a slim possibility that this will include a suspension of payroll taxes and minimum wage rules. If so, expect a stock market rally to follow.
Markets will also benefit from any perception that the Democrats will lose control of at least the House of Representatives. Markets like divided government because it means fewer surprises and fewer policy changes. Use any stock rallies in the next five months to raise some cash since opportunities always come along when market conditions are uncertain.
Too Big to Fail Hocum
By now you may be sick of hearing politicians and pundits mouthing off that 'we must never again expose taxpayers to having to bail out banks or others because they may cause financial disruption.' Equally popular is ' financial institutions will be less likely to take reckless risks if they know there will be no bailout if they fail.' When subjected to reasoning, both of these statements are patronizing nonsense.
Were GM and Chrysler bailed out because they were too big to fail? Nonsense, they were bailed out as political payback to the labor unions who's jobs and exaggerated benefits were in jeopardy. What did shareholders get, nothing. What did creditors get, next to nothing. What did the union workers get, about 85% of their existing claims and continued employment at wages that make government workers look abused.
The fact is that in a financial crisis or similar situations, the economy and therefore, taxpayers or voters (the choice is yours) are going to get hurt. The role of government is to apply the remedy that will lead to the least pain and disruption. If bailing one or more companies out is the lesser evil, then that is what should be done. If the answer is letting the companies fail and then authorizing stimulus spending to reduce the pain and shorten the recovery, do that. If you just don't know what to do, do both. Unfortunately, in our recent crisis, the third alternative was chosen because, as Hank Paulson's book clearly shows, they didn't have a clue.
As for a no bailout policy stopping reckless risk, forgetaboutit. No self-respecting chief executive thinks about failure or its consequences. He didn't get to be CEO by being cautious and his ego doesn't consider failure an option. Besides, his pay is based on high risk with other peoples' money for high reward for himself. For better or worse, that's the nub of the risk problem.
Bailouts are now a permanent part of government's playbook. Live with it. They are justified in some cases and politically valuable in others. Rhetorically, however, they will always fall in the category of insincere expressions reserved for things like the dollar "we are in favor of a strong dollar", balanced budgets "this bill will not cost taxpayers one dime", or inflation "we believe in low inflation"; expressions which defy serious discussion.
We live in an era where form trumps substance, perception overwhelms reality and spin drowns out truth. In short, we live in dangerous times.
This month is seeing that it doesn't require inflation to push interest rates higher. A healthy stock market can cause the same thing, and in much less time. In fact, there are a number of negative things at work which are helping rates rise, starting with the reluctance of China and others to buy more treasuries. This means US buyers have to step up and buy the trillion dollars of new government debt at a time when equities are looking more attractive. This is famously described as the 'crowding out effect' i.e. government using all the debt absorbing capacity in the market place.
Adding pressure to rates are the banks and hedge funds involved in the carry trade i.e. borrowing at the short term rate of 0.25% and buying 10 year treasuries yielding 3.84%. Do this with 10 to 20 times leverage and you're talking about some real money. The problem is that most of these carry trade positions were established when rates where more like 3.5% and today they are pushing 4%. With leverage, this means you need to unwind your position pronto. Since everyone is in the same boat, they are all sellers. Hence, as much as $500 billion in treasuries suddenly become for sale and the only buyer large enough to absorb the sell off will be the Fed. Since the Fed has no funds and only mortgage assets which no one wants to buy, they must print money â€“ voila, inflation.
Income investors may be tempted to move out of bonds and into stocks, especially if they feel a need to recover their losses from the last two years. While the short-term outlook for the stock market is positive, the longer term remains less so. We can expect a significant amount of capital gain realization before year-end by investors who want to avoid the higher tax rates in 2011 and the impact of this could go either way depending on how those sales proceeds are reinvested. My advice continues to be, position yourself for the next negative event, inflation, rather than chasing after the next market bubble.
Subscribers will recall that I have been warning that income investors begin preparing for an inevitable wave of inflation. I was early in this call, but inflation protected securities were dirt cheap so there was little to lose. Now, inflation protection is more expensive, but the need is more pressing. Specifically, the need is to move out of fixed rate issues. Consequently, I am changing my February recommendation for the portfolio mix from 30% in investment grade bonds and preferreds to only 10%, with the remaining 20% allocated to adjustable rate bonds and preferreds. I am broadening the range of inflation protected securities in this regard because the product availability is mainly from banking institutions and many of them have not yet gotten their investment grade ratings back. I don't consider this a serious shortfall because it is clear that none of these institutions will be allowed to fail, government posturing aside. I'm talking of the likes of Bank of America, Citibank and Morgan Stanley. They have been issuing a steady stream of inflation adjusted issues with a variety of adjustment formulas. Ask for issues with at least five years of call protection, a floor rate of 2.5% or better, an upside cap rate of no lower than 8% and an index tied to LIBOR, Treasuries or the CPI. Also make sure the adjustments are made no less than quarterly. We recently saw an offering of securities described as 'adjustable', but with the next adjustment being five years off! Others were tied to market indexes with hard to estimate price targets. The guiding rule for such offerings is, if you can't understand it, assume the worst. Aside from new issues, you can find our selection of adjustable rate securities on the website and among our closed end fund recommendations. Specifically, we have recommended AEB, GJI, GSA, GYB, HBA D, ORH B, PYV, PFL and JFP.
On the Brink
On the Brink - Inside the Race to Stop the Collapse of the Global Financial System" is Treasury Secretary Henry M Paulson's book of the financial crisis and how it was handled during his administration. It should be a roadmap for future leaders on how to handle a major financial crisis. It proves to be, however, a case study in just the opposite.
Paulson begins by telling us that he has great powers of memory and recall so that he kept no notes as events unfolded. Nevertheless, we are to feel assured his recall can be relied on. What results, however, is a superficial recounting of events with colorful anecdotes of little substance. One gets the distinct impression that our leadership in this crisis suffered the same blindness as the Fed and Treasury leaders of 1929, and this from Ben Bernanke, a student of the great depression. Paulson tells us time and again of his close working relationship with Bernanke and Tim Geithner, but the narrative is little more than a recitation of the phone log without giving a flavor for what was discussed.
The book has nary a harsh word for anyone and you would be hard put to find a villain in this piece. The exception was hard words for Senator Jim Bunning who apparently did not buy Paulson's brinkmanship. Bankers, regulators, congressmen, senators, presidential candidates, George Bush, Nancy Pelosi, Harry Reid, Barney Franks; all get pats on the back. What comes through here is that Paulson and Bernanke where in a unique situation in that a crisis was at hand for which no one in the political arena wanted a spotlight because they really didn't have a clue and feared getting blamed. Hence, they had carte blanche to experiment with previously untried solutions. The problem was, they too proved to be clueless.
The book draws a detailed time line of what actions were taken and what else was going on at the time which caused many decisions to be made with undue haste always to head off 'going over the brink', the mantra that silenced all debate then and even today. What is missing in Paulson's description of the major decisions taken is why a particular alternative was chosen when hindsight tells us that another alternative would probably have been better. For example, the decisions to pump over $100 billion into AIG to meet collateral calls arising from a credit rating downgrade of AIG. Had Treasury or the Fed simply provided a guarantee to AIG creditors for these obligations no money would have been needed. Also, we are now told the government will lose some $30 billion on this bailout while the company's stock trades at $28 instead of for pennies. Obviously, someone screwed up in designing this bailout. Given that Goldman Sachs, which Paulson was the previous CEO of, was a major recipient of this AIG largess it gave rise to a lot of suspicion which this book does nothing to assuage.
Paulson goes into detail about the various financial mergers which were facilitated for failed institutions; Bear Sterns, Merrill Lynch, Wachovia Bank, and Washington Mutual. Then they ended up putting billions of dollars of capital into the deals and providing billions more in loan guarantees. As a result, the top 10 financial institutions in the US now hold 60% of all financial assets, up from just 10% in 1990. Wouldn't it have been better to pump the same subsidies into the failing entities and let them work themselves out of their problems? Shouldn't that have at least been considered given that you have now created behemoth institutions that truly are too big to fail? My criticism of Paulson and Bernanke arises from having previously read a book which provides a much clearer picture of the financial crisis and how it was handled. The book is titled "Getting Off Track â€“ How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis" by John B. Taylor. Taylor is an Economics professor at Stanford University and is no lightweight when it comes to judging these matters. He is an expert on the Fed and author of the 'Taylor Rule' which is considered by many as the definitive guide the Fed should be using for setting interest rates. His book tries to answer the question, does Milton Friedman's summation of the great depression apply to our crisis i.e. "The great depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy." Taylor's conclusion is 'Yes'. He argues that the core mistake by Paulson and Bernanke was that they treated the crisis as a liquidity crisis rather than a crisis of confidence; confidence that the counter parties banks and investors were dealing with were sound. Hence, they flooded the market with cash rather than providing backstop guarantees as was done in Europe. He demonstrates this in a compelling way by showing how announcement of the TARP program caused the financial crisis to worsen in late 2008 rather than moderate. He concludes that the magnitude of the programs funding, some $700 billion, eroded confidence further because it defined the magnitude of the problem as much larger than the market had perceived it up to that point in time. Paulson supports this conclusion when he states in his book that he would have asked for even more money except he didn't want to spook the markets. As it turned out, the whole TARP program mutated into a capital injection program rather than the mortgage purchase program that was sold to Congress.
The overall impression of Paulson's stewardship of the financial crisis is that he was almost always behind the curve of events. Hence, his policies and actions were fire fights which left consequences which have still to play out.
The outlook for the economy in 2010 is dominated by debates in Washington DC regarding what can be done to improve both the jobs and the growth picture. It is also being influenced by Congressional committee discussions of legislative remedies to prevent a recurrence of the abuses that caused the financial crisis. What is unpromising about this is that it is not being perceived so much as a search for solutions as a search for political advantage. As a result, nothing is predictable. As a result, business and banking is marking time waiting for something to happen rather than trying to make good things happen. The problem with waiting for things to happen is that, more often than not, the happening is not for the better.
The President's budget proposal unveiled this week promises to generate a trillion dollar annual deficits for years to come despite there no longer being a financial crisis or deep recession. This represents not just a change in mind-set about the role of government, but also, an unsustainable financial situation that can only end in inflation. Government can only issue debt so long as there are willing buyers at reasonable interest rates. This is, so far, being achieved by the Fed by keeping short term rates artificially low so that banks and hedge funds can borrow at 25 basis points and use this money to buy treasuries yielding 3.5% to 4%. This is called the carry trade and it is going on today on a massive scale.
The systemic danger of this carry trade activity is that it is done by institutions which leverage themselves by 10 to 30 times. This means they absolutely cannot afford to have long-term interest rates, which the Fed doesn't control, go up. A rise in rates means the value of their holdings will quickly drop much more than all the interest they have earned on those holdings. In short, at the first sign that interest rates will rise, the carry trade bubble will burst and everyone will rush to sell. Unfortunately, the only big buyer for these treasuries will be the Fed and, given the state of its balance sheet, the only way it will be able to pay for them is by printing more money. That is when inflation will begin. This carry trade bubble is around the $500 billion dollar level and growing. The bigger it gets, the more danger, since there is no foreseeable way for it to deflate short of bursting. A spike in long term rates can be triggered by financial news, fear of new government regulations, an international event or even a rumor. It is a fragile thread by which today's economy hangs. When government intervenes with policies that are strongly driven by political considerations, the hopes for a positive outcome are slim. My message for 2010 is, take a defensive posture that anticipates an inflationary outcome. By the time you see actual inflation, it will already be priced into most financial securities.
Looking Into 2010
We enter the new year relieved that the trauma of 2009 is behind us, or is it? While there is limited concern that the problems of the recent past will resurface, there is legitimate concern that the remedies applied in 2009 will come to haunt us. These are the unintended consequences that occur when major policy actions are taken without precedent or thorough planning. Who has forecast that those consequences may well be worse in the long term than the positives gained for the short term? Keep in mind that for politicians, the only term that matters is their term in office. As for the Federal Reserve Bank, we are told they helped precipitate the financial crisis by keeping interest rates too low thereby causing the housing bubble. Are we now to believe that the remedy for the fallout from that crisis is even more low Fed interest rates? History tells us that all these policy moves will result in inflation. Income investors who believe the happy talk being put out by government spokesmen or media pundits will pay a price. Given the volume of TV ads for gold, I suspect there is significant skepticism out there. We know the Fed cannot control the long-term interest rates and it is these debt holders who will revolt first and demand higher yields. This will pull even more money into long term/short term interest rate arbitrage and thus force up short-term rates as well. The remedy for this uncertainty is diversification. As I point out in my book, Income Investing Today, you want to diversify over a variety of income drivers which are not all sensitive to the same economic factors. For 2010 we make some basic assumptions;inflation will begin, interest rates will rise, the stock market will rise, and commodities will rise. To protect against interest rate rises, buy some adjustable rate bonds and preferreds. You give up about 2% in current yield, but you avoid a capital erosion once rates begin to rise. In fact, if you buy instruments trading below par value, you will actually see them migrate back to par as rates rise in addition to seeing an ever increasing current yield. Convertible securities are the answer to a diversification that provides exposure to the stock market. Stocks are more likely to rise than fall should inflation begin. Commodity stocks are another diversification that should be added, especially energy related oil trusts or limited partnerships. Commodities have a world price which is somewhat independent of economic conditions in the United States. While gold is not an income producing asset, it does provide excellent protection against capital erosion when inflation comes. Investors should build a position in gold over time of at least 10% of their holdings, especially when the inflation threat is so glaring. Donâ€™t be discouraged by the current high prices, over time gold will never be your worst investment decision. Once inflation comes, REITs and other financial and housing related investments become attractive and should be pursued, but wait for events to unfold. Remember that once inflation starts, it lasts quite a while and can run to extremes.
Once again, we take measure of how our model portfolios did for 2009. Despite a strong stock market in 2009, fixed income more than held its own and finished the decade miles ahead of equities.What is evident from these results is that income investing is not only a lower risk approach, it is also a higher return strategy. This was not just a one or two year occurrence, but as can be seen, a truth for most years of the decade. This is good news for the millions of boomers preparing for retirement but still needing to grow their nest eggs. January is the month we roll out our model portfolios for 2010. This annual change does not mean the prior year portfolios are no longer valid, it only means new or certain old securities are now a better buy. Note also that many of last yearâ€™s selections continue in the current yearâ€™s portfolios. The changes also reflect our aversion to certain industries and preference for other sectors or changes in their weighting in the overall mix. Interest rates moved higher on a sharp rise in the ten year Treasuries to 3.84% , an increase of 65 basis points or 20.3% in a month. Reports on who is buying all the new Treasury debt attribute over $500 billion of the purchases to a category called â€˜Other.â€™ It would be a fair guess to assume that â€˜Otherâ€™ means carry trade players including hedge funds and banks. Such purchases are being funded with Fed lending and artificially low short term rates. This is why you are hearing comments about the Fed running a Ponzi scheme. This hot money investing can unravel dramatically once the Fed begins to raise short term rates. That could mean long term rates could spike upwards almost overnight leading to more international financial drama. Junk bond yields continue to decline, dropping about 5% for the month. These bonds were the best performers in 2009, but represent an investment with a high risk outlook. A default wave in these securities has been delayed by the banksâ€™ distraction with their bad mortgage portfolios. Once they work themselves through their mortgage problems I fully expect them to address their troubled corporate clients. Use the current high prices to reduce your holding.
Preparing for Year-End
This may be the first year-end in some time in
which you have some positive decisions to
make regarding your investment portfolio, i.e.
taking profits. While I am not advocating selling your
winners just to use some of your loss carryforward,
it is a good time to re-balance your
portfolio. Following an effective diversification
strategy means periodic re-balancing to the
allocation currently most prudent.
For the coming year I am recommending an
allocation as follows:
Investment Grade Bonds/Preferreds........30%
Convertibles and CEFs.............................20%
The allocation to investment grade bonds and preferreds should be equally weighed between fixed rate and adjustable rate securities. In the adjustable rate, look for those yielding about 5%, but trading at 80% or less of their par value. See a list of suggested securities on Page 2. These securities normally trade near par but are lower because of the financial crisis and because they are tied to an index which is currently well below the floor rate of the security (often about 3%). Once inflation kicks-in, the capital gain more than makes up for the lower current yield. Convertible and closed-end funds provide you with income as well as a participation in a stock market recovery. They can also serve a dual purpose in your effort at diversification if you buy energy or commodity based companies or funds. We can all see gold setting new records daily and this has held back many investors. There is no obvious entry point here other than yesterday, so you should build up a position in these metals over time. Yes there may be pull-backs, but the inflation outlook argues for a long term position in precious metals. The recommended cash allocation is high because there is presently a lot of uncertainty and that means opportunities. My diversification strategy argues that there is no clear path so cover all the bases. There are though, a number of areas which are not represented here which could prove opportune in the coming months. Also, special situations come up throughout the year and it is better to pursue these without having to sell a position. The areas to avoid for new buys are junk bonds (with the exception of those we still recommend holding), almost all REITs, long term U.S. Treasury bonds, all municipal bonds and all mortgage backed securities. Although junk bonds have been hot this year, a default wave of these securities is still very likely. As for long-term investment grade bonds, they are yielding in the 3% to 4% area that leaves little room for price improvement but miles of room for price erosion as inflation heats up. Sell those trading at prices over their par value and a low yield to maturity. You will note from the Comparative Current Yields table on Page 10 that yields on preferred securities rose in November while everything else was falling. There is no clear reason for this, so look on it as a buying opportunity.
The following paragraphs were taken from my book â€œIncome Investing Todayâ€� published in 2007 before the financial crisis. They seem to hold true today except the more obvious risks now are credit and inflation. Ask ten investors how they define risk and, chances are, you will get at least five different answers. In a recent prospectus for a new mutual fund I counted no fewer than 28 defined risks and this did not include risks based on dishonesty such as after hours trading in fund shares, over-pricing infrequently traded holdings or the front-running (buying for your own account before making market moving trades for your fund) of fund purchases. The point is, while 28 different risks may exist, the degree of each fluctuates according to economic, political or market conditions. The most common risk concern among investors is credit (payment) risk. Thatâ€™s why many investors buy only government backed debt or FDIC insured CDs. Yet today, when I rank the various risks by their likelihood, credit risk is quite low. Think about it this way, investment risk is a moving target that can be parsed into as many as 28 components. Taken to their extreme, each of these 28 risks can cause major short term or long term damage to ones portfolio. The challenge for the investor is identifying which risks are currently the highest and whether he should or should not react to them. For example, if credit risk were suddenly a great concern, everyone would likely react. However, if the risk is interest rates rising, not all investors would react. An income investor with a laddered portfolio wouldnâ€™t be concerned because his income remains the same and so does his principal maturity value. On the other hand, the investor seeking growth and income would despair because the market value of his holdings has contracted. Looking to the future, I see the following risks as high: interest rate risk, industry specific risks (REITS, financial institutions), political risk (election and Fed policy related), financial system risk (derivative and dollar currency related), market disruption (terrorism related) risk and inflation risk. This is even more complicated when you consider that the risk result can appear to be positive or negative and the consequence can be predictable (interest rates rise -, bond prices fall) or contrary (Congress is re-elected -, stock prices fall!). It is precisely because risks come in such varieties that forecasting accuracy is so poor.